May 14, 2021
The American Prospect
One way that private equity (PE) firms have historically been able to take on larger and larger companies is through the use of so-called “club deals.” This refers to when two or more private equity funds join together to acquire a huge enterprise, and share ownership. Once a more common structure, club deals have declined from more than 40 percent of all leveraged buyouts (LBOs) (not including add-ons) in 2004 to just 20 percent in 2018. Burned by past agreements that promised high returns but ended in distress or bankruptcy, pension funds and other limited partners grew leery of these deals.
But memories of these failures, some spectacular, have faded as a new generation of general partners takes the helm in PE investing. Recent reports indicate that Medline Industries, the nation’s largest manufacturer and distributor of medical supplies to hospitals and doctors’ offices, valued at more than $30 billion, is in the crosshairs of three separate private equity clubs, all vying to win the bid. Advent International, Bain Capital, and CVC Capital Partners formed one group; KKR and Clayton, Dubilier & Rice have formed a second; and Blackstone and Hellman & Friedman have formed a third.
The recent bankruptcy and liquidation of Toys“R”Us, a club deal owned by Bain, KKR, and Vornado, was not a one-off aberration. A short walk down memory lane may remind limited partners of the risks from failures on the scale of these megadeals. All the examples below are from my book, co-authored with Rosemary Batt, Private Equity at Work: When Wall Street Manages Main Street:
In 2006, Tishman Speyer and BlackRock combined to purchase the landmark Manhattan rent-controlled apartment complex, Stuyvesant Town-Peter Cooper Village for $5.4 billion. Their intent was to raise rents in order to drive out the tenants, convert the apartments to condos, and sell them in the booming New York City housing market. The investment failed when the tenants successfully organized to resist these efforts. The PE owners defaulted on their debt in 2010. In the bankruptcy, they owed the tenants over $200 million in illegal overpayments on rent. The limited partners, including the Church of England, the government of Singapore, and three public employee pension funds in Florida and California, lost a total of $850 million.
In 2007, KKR, TPG, and Goldman Sachs Capital Partners joined together in a club deal to acquire Texas energy company TXU for $48 billion, making it the largest leveraged buyout in history. The acquisition was financed with $40 billion in debt. TXU employed nearly 7,300 workers and served 2 million customers. The three elite firms in this deal made a one-way bet that the price of natural gas, which TXU produced, would rise. But they were wrong; natural gas prices fell in the ensuing years, due to a drop in demand during the Great Recession and a surge in additional supply. Just seven years after the company, now known as Energy Future Holdings, was acquired, it failed to make a scheduled debt payment and was forced into bankruptcy. The PE firms, which had put up a tiny fraction of the equity, emerged unharmed, having pulled out $538 million from the company by 2012 and millions more later in advisory and monitoring fees that they were not obliged to share, plus management fees the limited partners paid to the PE firms. Investors in the TPG fund wound up carrying Energy Future Holdings at just 5 cents on the dollar by 2012, with 95 percent of their investment wiped out prior to the bankruptcy.
Mervyn’s Department Store, a major mid-tier retailer with 30,000 employees and 257 stores, was acquired by a consortium of Cerberus Capital Management, Sun Capital Partners, and Lubler-Adler & Klaff Partners in 2004. The PE firms stripped the retail chain’s real estate assets, sold them to a real estate investment trust, pocketed the proceeds, and saddled the stores with high rents that dragged down their ability to compete. They ended programs in their local communities—summer lunch programs for students, a baseball field for the high school, sponsorship of local events—that had won the loyalty of generations of shoppers. They slowed payments to vendors, which in turn delayed delivery of merchandise to stores, missing back-to-school and other high-revenue opportunities. In 2008, the company’s PE owners took it into bankruptcy, wiping out the equity investment of their limited partners in the retail chain. It was liquidated, costing thousands of workers their jobs, causing hundreds of malls and Main Streets to lose their anchor stores, and leaving dozens of vendors unpaid. A few months later, the vendors sued Mervyn’s PE owners and other parties for fraudulent conveyance in the sale of the chain’s real estate and breach of fiduciary duty to Mervyn’s and its creditors. The complaint was settled in 2012 when Cerberus Capital Management, Sun Capital Partners, and Lubler-Adler & Klaff Partners agreed to pay the vendors $166 million.
The list goes on. It’s worth noting that troubled club deals that don’t end in bankruptcy can still cause pain for the acquired company and its workers, and can be a flop for the PE firms’ limited partner investors. Harrah’s Entertainment, the world’s largest casino with 30,440 unionized employees at the time of its acquisition by Apollo Group and TPG in 2006 (for $30.7 billion), struggled under the debt leveraged on it to finance the sale. Now known as Caesars Entertainment, the company cut staff, reduced hours, and scrapped plans for a 2010 IPO, with shares offered at $15 to $17. Strapped for cash, its PE owners took Caesars public in an IPO with shares sold at $9 a share, a 40 percent haircut for limited partners.
Similarly, Buffets Holdings restaurant chain, which at its peak operated more than 600 restaurants under multiple brand names and employed 36,000 workers, was acquired by Caxton-Iseman and Sentinel Capital Partners in 2000. Over the years, the company took out $250 million in dividend recapitalizations and millions more in advisory and monitoring fees. By 2008, the restaurant chain could not meet its financial obligations and filed for bankruptcy. This wiped out the limited partners’ equity in the chain. The PE owners were sued by Buffets, which alleged that they had drained the company of resources and driven it into bankruptcy. The case was settled for $23 million. The chain survived reorganization, but many restaurants were shuttered and thousands of workers lost their jobs.
Medline Industries is a highly successful company with no low-hanging fruit in the form of operational, marketing, or business strategy improvements requiring PE’s secret sauce. Financial engineering is the fate that awaits Medline, with estimates that it will be burdened by $10 billion in debt used to finance the private equity takeover. It can look forward to a management services agreement in which it will pay millions of dollars annually to the PE firms for advisory and monitoring services. The PE firms may keep all of these fees or, at their discretion, share some of them with their limited partners. Medline can also expect to be required to sell junk bonds to finance dividend payments to the limited partners and, via the general partner, to the PE firm. Medline Industries is a successful company today, but if it cannot manage to service a new $10 billion debt (and how many companies could?), it may default on its debt and enter bankruptcy, wiping out the equity of the PE firms’ limited partners.
Of course, the PE firms pursuing a possible leveraged buyout of Medline Industries believe they have a strategy for ultimately exiting this club mega-investment at a profit. They may well be right, but a generation of limited partners have passed on these deals out of an abundance of caution, remembering how other promising club deals left them out in the cold. Today’s limited partners have to consider whether there are lessons in these earlier experiences, or if it’s really time for a return to megabuyouts and club deals.
Plus, policymakers should consider whether club deals are worth the risks, and if they believe they’re too dangerous to workers, investors, creditors and the broader economy, undertake strategies to ensure that they don’t occur. Just because the doors have been flung open for club deals doesn’t mean that we all have to live with the consequences.